Environmental Accounting and Reporting 101
by Charles J. Coate
University of Kansas
Karen J. Frey
Nikkie S. Sakuvich
Spring, Corporate Audit Services
Accountant's eye shades may soon be turning from money green to environmental
green. Why? Because environmental accounting and reporting are of increasing
importance for businesses. Environmental accounting deals with recognizing
and disclosing a company's environmental costs and liabilities in financial
reports. Because the concepts are relatively new, environmental accounting
may not be covered in the text or even listed in the index of your favorite
accounting book. However, some more recent textbooks (Wallace, p. 954;
Horngren, et. al, p. 435) contain a paragraph or two on the issue, and
professional and academic journals are more commonly addressing the subject.
As environmental issues and their related costs grow in dollar size and
in public awareness, accounting professionals must be prepared to incorporate
their impact into financial decisions and reports.
Environmental expenses have been estimated to be between two and five
percent of the gross national product (GNP). Legal and regulatory requirements
imposed on environmental wrongdoers formally drive these expenditures.
However, consumers are more frequently considering a company's environmental
responsibility in deciding whether to purchase its products or services.
Hence, good business practice can require that firms abide by "socially
imposed regulations" as well. Environmental responsibility, then,
may not only protect the firm from a variety of charges from government
agencies, but also enhance its reputation in the community.
Yet, even as businesses become more aware of environmental liabilities,
they are often uncertain how to account for them. Surveys by Price Waterhouse
revealed that, at one time, most respondents with known exposure to environmental
liabilities were reluctant or slow to record them in the financial statements.
As late as 1990, only a small minority of firms had policies to address
environmental issues. More recently, the trend has been to increasing
disclosures and/or recording of environmental liabilities. By 1995, most
companies had developed formal statements of environmental policies.
Federal Environmental Acts and Environmental Audits
Environmental costs and liabilities are primarily driven by increasing
federal regulation and enforcement. Federal environmental acts establish
requirements for remediation, abatement, and prevention of hazardous waste
sites. The three major acts are:
- The Comprehensive Environmental Response, Compensation,
and Liability Act of 1980 (CERCLA). Better known as Superfund, this
act requires potentially responsible parties (PRPs) to incur costs for
remediation. The EPA identifies PRPs as firms with operations involving
hazardous waste and site contamination.
- The Resource Conservation and Recovery Act of 1976 (RCRA)
is concerned with preventing events that could lead to contamination
and result in the need for future site cleanups. It establishes responsibility
for the monitoring, transportation, treatment, storage, and disposal
of hazardous wastes.
- The Clean Air Act Amendments of 1990 (CAAA) attempt to
reduce pollution by requiring public utilities to restrict the amount
of sulfur dioxide and nitrogen oxides that their generating units may
Violation of these statutes can result insignificant fines, remediation
costs, or even imprisonment. The EPA, through the Department of Justice,
charges 5 to 10 engineers and business people per week with criminal violations
of environmental regulations. Liability for environmental wrongdoing is
strict, joint and several, and retroactive. Furthermore, lack of knowledge
is not a defense and negligence may result in imprisonment. thus, companies
need to be particularly careful when dealing with environmental laws.
As with legal liabilities, accountants must rely on the work and opinions
of experts in other fields to determine the impact of environmental issues.
Firms may undergo an environmental audit to determine the legislation
applicable to the firm, to assess the compliance of the firm with the
legislation, and to assist in estimating environmental liabilities.
A team of internal and external experts, including environmental engineers
and legal counsel, performs the audit. The team reports findings to company
management by issuing a formal environmental audit report. Where appropriate,
this report includes recommendations for attaining regulatory compliance
and improving environmental cost efficiency.
Recording Environmental Liabilities
Although accounting for environmental exposure is one of the six issues
considered tremendously important to the SEC, no environmental-specific
GAAP has yet been issued. Accountants rely on existing GAAP (FASB #5,
FIN #14) to account for environmental issues. Consequently, there is an
increasing need for accountants to be familiar with the substance of and
potential financial treatment of environmental liabilities and costs.
Currently, the major financial accounting issue in environmental accounting
is estimating and recording environmental liabilities in the financial
statements. Treating environmental costs as loss contingencies is most
common in practice. FASB #5 provides guidance in defining and determining
how to report loss contingencies, and FIN #14 provides guidance in estimating
them. FASB #5 defines a loss contingency as:
An existing condition, situation or set of circumstances involving uncertainty
as to possible gain or loss to an enterprise that will ultimately be resolved
when one or more future events occur or fail to occur.
Environmental liabilities often fit this description. The possibility
of a company's noncompliance with environmental regulations is the "uncertain
condition." The "future event" that resolves his uncertain
condition is the declaration by regulatory agencies that the company is
or is not liable to pay damages for harming the environment.
To test your readiness for the world of environmental accounting, try
the short quiz below. These questions represent the types of challenges
accountants routinely face as new GAAP emerge.
In questions 1-3, suggest the appropriate accounting treatment for each
of the situations. In questions 4 and 5, provide a short answer. You have
one professional career to complete this quiz.
Question 1: Suppose a pharmaceutical company is concerned that its disposal
of hazardous waste may not be in compliance with recent environmental
regulations, and hires a consulting team to perform an environmental audit.
The team assesses the likelihood that the firm will be liable for cleanup
costs as probable. The team's report further reveals that:
-The average cost for similar cleanups is unknown.
-The lowest cost estimate for this cleanup is $1 million.
-The most this cleanup will cost is $10 million.
-Evolving technology may reduce the cost of this cleanup to $500,000.
Question 2: Suppose, in contrast to question 1, the firm must decontaminate
land rather than waste materials. Ten years prior to the environmental
regulation requiring the cleanup, the land was purchased for $4,000,000.
Current market value in the absence of any environmental liabilities is
Question 3: Now suppose a firm purchases two similar tracts of land. Tract
A is pollution-free and the firm pays $7,000,000. Tract B is purchased
with pre-existing pollution (i.e., the firm did not contribute to its
hazardous nature) with an estimated $1,000,000 cleanup cost. The firm
paid $6,000,000 got Trace B. The cleanup of Tract B has begun ($500,000
expenditure), but is not complete.
Question 4: Are timing issues important considerations in environmental
Question 5: How do the established concepts of 1) subsequent events, 2)
changes in accounting estimates, and 3) accounting errors relate to environmental
Question 1. FASB #5 requires the accrual of a loss contingency, because
the likelihood of loss is probable and the amount of the loss is estimable.
FIN #14 requires that the minimum be accrued, when the reasonable estimate
of a loss is a range, and no amount within the range is a better estimate
than another. Thus, the firm should record a $1 million environmental
liability and expense on the balance sheet and income statement, respectively:
Notes to the financial statements must disclose the nature and amount
of the potential liability.
Question 2. Questions like these must be carefully considered in the absence
of environmental-specific GAAP. (Translation, there may be no right answer).
Nonetheless, here are some questions to consider in formulating an "answer."
Should the association of the environmental expenditure with site contamination
rather than waste disposal change the accounting treatment? Specifically,
since the contamination can now be associated with a particular asset,
should the book value of the land be reduced? If setting up a contra asset
account is an appropriate treatment, should cleanup expenditures be taken
against this contra account? If the liability is greater than the book
value of the land, should the land be presented as a liability?
Question 3. The value of Tract B is greatly increased by the cleanup.
Should both tracts be recorded at cost? And if so, should the cleanup
expenditures increase the land's book value (similar to capitalizing capital
improvements)? If the firm, unaware of the pollution, purchased Tract
B for $7,000,000, how should the environmental cleanup be recorded when
Question 4. Yes. Because . . . well . . .er . . I think you get the idea.
But, think about the following. Consider that environmental cleanup may
involve contaminated materials accumulated over the past three years,
while the relevant environmental regulation became effective in the current
year. The question arises whether the environmental expenses should be
recognized in the period the regulation becomes effective, or during the
period of physical contamination; that is, whether the expense should
be recorded in the current period or in past periods. Or, if a new environmental
regulation is to become effective next year, are there circumstances when
environmental expenses should be recorded in the current year?
Environmental cleanup technology provides another twist to the timing
issue. Suppose the firm has a $l,000,000 environmental liability accrued
from the prior year. In the current year, prior to cleanup, new technology
becomes available and the actual cleanup cost is $500,000. In what period
should the reduction be recorded?
Question 5. You're on your own here. It's time to go out into the "real
Managerial Accounting and Auditing Concerns.
The impact of environmental issues on accounting professionals is not
limited to financial reporting. It affects managerial accounting, environmental
costs must be recognized, measured, and included in product costs and
firm decisions. Practitioner journals are already responding to this need
(Kreuze & Newell, 1994; Brooks, et. al, 1993). In auditing, environmental
issues present substantial challenges. Not only muse auditors attest to
the fairness and appropriateness of recorded environmental issues, but
they must be aware of possible unrecorded environmental liabilities.
Environmental issues have increased in importance in past decades. That
this trend promises to continue is reflected in the increasing financial
attention firms are giving to these issues. Thus, accountants need to
be aware of environmental issues and to consider their influence upon
both internal and external reporting.
The evolution of the appropriate financial treatment (GAAP) for these
issues will provide challenges to accounting professionals. This evolution
is interesting both for its own sake and also for the perspective it provides
on other emerging GAAP issues.
Anonymous. 1995. Price Waterhouse Study Focuses on Environmental Practices.
Environmental Manager 10 (May): 11-12.
Brooks, P.L., L.J. Davidson and J. H. Palamides. 1993. Environmental Compliance:
You Better Know Your ABCs. Occupational Hazards (February): 41-46.
FASB Statement of Financial Accounting Standards No. 5, "Accounting
for Contingencies," 1975, par. 1.
Horngren, C.T., G. Foster and S. M. Datar. 1994. Cost Accounting : A Managerial
Kreuze, J. and G. Newell. 1994. ABC and Life Cycle Costing for Environmental
Expenditures. Management Accounting (February): 38-42.
Wallace, W. A. 1995. Auditing (Third Edition). SouthWestern College Publishing.